Arnold Kling  

Self-Defense on Predatory Lending

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I don't do well in back-and-forth blog spats, but I want to reply to the anonymous blogger at The Economist, who is jumping to the conclusion that I am ignorant, when I believe I know what I am talking about.

The issue is predatory lending, and he points out that mortgage brokers could make a profit by making risky loans and selling them to investors. But that is not predatory lending, as I would define it. The mortgage broker is taking advantage of the investor in the loan, not the borrower (mortgage brokers try to take advantage of borrowers, too, but that is another story). When I was with Freddie Mac, we assumed that mortgage brokers were scum who would try to pawn off bad loans, and we took all sorts of steps to try to avoid buying such loans. It was not because we felt sorry for the borrowers. It was because we did not want to lose money.

Mortgage brokers always make money by selling loans. They never make money by turning down a borrower. That is why investors have to be wary.

Is it preying on the borrower to make a bad loan? Not so much. The borrower gets a free option. If the house price goes up, it doesn't matter whether the borrower can make the payments or not--the borrower can sell the house at a profit. If the house price goes down, the borrower loses his down payment, plus moving expenses, plus a ding on his credit rating. As down payments approached zero, the total down side of this was pretty small.

The "prey" of the predatory lending in recent years was not the borrower. It was the investor. Investors turned into suckers. I don't feel sorry for them. If you want me to feel sorry for the borrowers, you have to convince me that they lost more than I understand they did.

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COMMENTS (9 to date)
SydB writes:

"I don't do well in back-and-forth blog spats"

I see no need for terms like "self defense" and "spats." The world is full of differences of opinion, and to characterize these differences as requiring self defense and as spats is part of the problem. Also, do note that everything at the Economist is anonymous. By design. The magazine is entirely editorial in nature.

As far as substance, I'd say that Mr Kling's terminology is probably more accurate. Tyler Cowen in fact uses the term predatory borrowing to describe much of what happened.

But...the mortgage broker is part of the lending process, the lending mechanism. There is a lender--aggregate that it may be--and a borrower--a person. And loans were made to borrowers who would with a high probability default. I think that is predatory. Selling people a loan they could not afford. E.g. from Wikipedia: OCC Advisory Letter AL 2003-2 includes in its definition of predatory lending "Using loan terms or structures – such as negative amortization – to make it more difficult or impossible for borrowers to reduce or repay their indebtedness;"

Matt writes:

I think this is another sign that people haven't really lost the bias towards home ownership that was responsible for so much willful blindness during the bubble.

I'm part of a generation that for most of our working lives have seen house prices rise faster than our incomes and for whom the prospect of home ownership has seemed ever less obtainable every year. As a result I and many of my peers have never been in the position of seeing rising house prices as an inherently good thing.

For anyone with a basic grasp of math and the knowledge of history or childhood memory of 20% interest rates, taking on huge mortgage debt seemed obviously speculative even without really understanding what was going on in the housing and mortgage market. One comfort when less cautious friends were 'making' more than my annual salary in house price appreciation in one year was the knowledge that I wasn't exposed to the risk of a downturn in housing prices or an increase in interest rates.

Of course now I understand what was really going on all those years and see how no effort is spared to help the incautious and no thought spared for the prudent I realize that the real fools were those of us who thought that the rules of the game were fixed. That turned out to be true but our mistake was to think 'fixed' meant 'unchanging'.

Yehuda writes:

It wasn't predatory lending in the sense you're describing, it was lending that didn't price in the costs of the massive negative externality it created. This lending increased the risk of a crash and at the same time raised housing prices even further, which increased the harm from the crash to borrowers who were not a bad risk.

The people most injured here are those who put reasonable down payments on their houses and bought within their means over the last few years. This is especially true if they have the ability and sense of responsibility to continue paying mortgages on their underwater homes.

The investor was the prey but those most harmed were third-parties.

mulp writes:

So, if Arnold Kling were told he only qualifies for a 3% interest only for three year ARM with an APR of prime plus 7% which can easily be refi'd in three years, and those obsolete 30 year fixed 5% loans are no longer available because Congress has disbanded the reckless Fannie Mae that created the crisis by forcing unaffordable loans on home owners. That this loan is a much better deal because you pay only 3% interest for three years instead of 5% for those bad 30 year fixed that require you pay principle too.

And most important of all, the government isn't regulating it, but the highly respectable Goldman Sacks, a bank almost as old as the Civil War is financing it, would Arnold say, "wow, what a great deal, I'll take it."? Or would he tell the mortgage broker that he's not going to sell him on a really bad predatory loan.

What did happen tens if not hundreds of thousands of times is older people who bought homes ages ago when that evil government was dictating the loan terms and forcing their people into rigid 30 year fixed rate mortgages with 20% down and a year or two of steady employment. So, now a banker tells them they can borrow against their paid up house with a better deal because they are great credit risks, how can this older couple with medical bills and a new roof needed be making a bad decision. Bankers never made loans that couldn't be paid off. How could this couple go wrong? No banker is going to make a bad loan, because they have been telling this couple that going back 50 years.

Charlie writes:

I agree with everything you said. It was the investors, and typically, the large institutional investors that were left holding the bad either because of fraud or being asleep at the wheel or some combination of both.

That said, the CFPA doesn't seem bad. Getting away from exotic loans on net seems like a good thing. And forcing loan terms to be more transparent just seems like a good idea. For instance, an idea to make prepayment penalties illegal was floated back at the end of 2007 by David Laibson and approved by Mankiw and Delong and still seems like a good idea.

One question: You used to push hard for 20% downpayments, was that as a top down regulation or something else? I thought it was a regulation, but Russ Roberts seemed to think it was just your opinion of what the market outcome would be absent government.

Tracy W writes:

Bankers never made loans that couldn't be paid off.

Really? When did people believe this? I thought the nasty banker was a stock character from fiction. And people recognised the joke:
A bank is a place where they lend you an umbrella in fair weather and ask for it back when it begins to rain.
Mark Twain 1835-1910

And did this older couple not know about the Great Depression? Or anyone who got into trouble borrowing money for their house?

Bill Woolsey writes:

Suppose you start with the assumption that the relative price of homes at their peak was the right price (or really, that they should keep on rising providing great capital gains.) Further assume that all of the poor people who purchased homes had a right to homeownership.

Given those constraints, what could have possibly been the problem? Lenders gouged poor borrowers by making them pay more than they could afford. Further, since _any_ interest is really unearned usury anyway, this is pretty obvious.

If, on the other hand, you prefer the "conservative" story, that money was lent to a bunch of poor people who didn't merit receiving a house, because they hadn't worked hard enough or saved enough, then you don't need to focus on the lender gouging story.

The deserving homeowners, who saved up for a down payment and could afford their monthly payments out of income, deserved both their homes and the great past and future capital gains. The problem is that the banks lent to people who couldn't afford to pay the money back.

And, of course, if the problem was buying overpriced homes because of a foolish expectation that past price increases create a reasonable expectation of future price increases, and that this problem was exacerbated by lenders being willing to lend against overpriced homes, then "gouging" of poor borrowers by lenders seems pretty irrelevant.

Keep in mind that layman's price theory has perfectly elastic supply and demand with bargaining power determining price. Gouging is a constant threat. Of course we need government to protect consumers against unfair pricing.

I think it is pretty obvious why Democrats have to make protecting borrowers against predatory lending a key element of "reform."

stephen writes:

I could be wrong but it seems that the set of folks who believe the predatory lending story intersect heavily with the set of folks who believe that mortgage modification would be beneficial for the lenders/investors on net. These ideas seem mutually exclusive.

SteveR writes:

Discussions may be missing the bigger picture.

Why was there a market for mortgage brokers at all? It seems like cap regs (Basel/AAAs/etc.) & political enablements (GSEs/gov't programs/etc.) created excess demand.

Lots of primary (investor) and collateral (good buyer/owner) damage occurs when incentives are distorted.

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